Exchanges’ Regulatory Role Draws Closer Scrutiny

The latest regulatory penalty levied against a major U.S. exchange is seen spurring a deeper review of exchanges’ dual role as market operators and supervisors.

The Securities and Exchange Commission’s $6 million settlement with the Chicago Board Options Exchange, resolving allegations that the CBOE failed in its regulatory duties, provides fresh ammunition for critics who see conflicts of interest in exchanges regulating their own customers.

“This really demonstrates the need for reform regarding self-regulatory organizations,” said Christopher Nagy, a consultant who specializes in exchange issues.

The CBOE matter centered on the exchange allegedly mismanaging an investigation into a member firm and then providing improper help to the firm when federal regulators took up the issue. The exchange didn’t admit to or deny to allegations.

The matter is the latest in a string of alleged missteps that have called into question exchanges’ legal status and cost their corporate parents millions to settle.

Nasdaq OMX last month paid $10 million to the SEC to settle a range of charges centered on Facebook Inc.’s botched debut on the Nasdaq Stock Market in 2012, which drove an estimated $500 million in losses for Wall Street firms NYSE Euronext last year paid $5 million to resolve an investigation into a data feed that regulators alleged provided prices to some customers ahead of others, while neither admitting nor denying the allegations.

The SEC actions against exchanges carry extra significance because U.S. securities law gives exchanges regulatory power over their own markets, as so-called “self-regulatory organizations.” Such entities are able to craft rules around trading and have responsibility for policing their markets, while the SEC regulates exchanges themselves and creates market-wide rules.

While many exchanges have outsourced surveillance and examination to the Financial Industry Regulatory Authority, an independent agency, exchanges still retain some protections against legal actions brought by financial firms. This limits their liability for losses suffered by firms when exchange systems break down.

Firms in the past year have challenged the structure, and some senior regulators have also questioned it. SEC Commissioner Daniel Gallagher said last fall that exchanges’ existing regulatory status “doesn’t make much sense to me,” when comparing the privileges and burdens that come with running an exchange. He said the SEC should examine the issue.

“This fine, coupled with the Facebook issue and others, could put into play… some proposals regarding SRO reform,” said Mr. Nagy. A spokesman for the SEC declined comment.